In several cities, the real estate market is about to drop even more. Home values in many of those cities, such as Las Vegas, have already collapsed as unemployment has shot higher. And with no hope of quick recovery, housing prices are expected to continue to fall. 24/7 Wall St. identified ten housing markets that are expected to drop by at least another 10 percent by 2012.

Methodology: We used data from the Fiserv Case-Shiller Indexes, which track real estate activity in 380 cities. We selected those that are forecast to have the largest percent price drop between the first quarter of this year and the first quarter of next. We added several other pieces of information to our city-by-city information, including June unemployment levels, median household income, and when home prices are expected to reach their troughs in each market.

Median household income in these cities tended to be near the U.S. median, and in some cases well below. We expected to find high unemployment in these cities. This turned out to be the case. In all but one of the cities we examined, unemployment was well above the national average. The rate was over 18 percent in two of the cities. This link between unemployment and expected future drop in home prices shows again how insidious the housing price problem is.

Home prices fell from all-time highs in 2006. Home equity tapped by second mortgages had been a tremendous source of income then for families who used it for retirement saving, education, and simple consumer purchases. Three years later, many of those homes were worth less than their mortgages. A large population of homeowners still owed a second mortgage. The burden of those two home loans happened to come at a time when national unemployment rose from 4 percent in the mid-2000s to 10 percent. The mix of unemployment and high mortgage payments ripped the home market apart.

The ten markets on the 24/7 Wall St. list of “Housing Markets That Will Collapse This Year,” and several other like them, may not see a full recovery in home prices for years. Inventories in these markets tend to be large. Demand tends to be low as the unemployed cannot be buyers.

Finally, fear of further price drops all exacerbate the problem. No person or organization, including the federal government, has been able to help support the housing market, although the administration has tried. Not a single plan has built even a thin net under home values, despite the best efforts of the best economic minds in the world.

10. Fort Lauderdale, Fla.

Expected price drop: -11.1 percent

Median family income: $58,800 (194th highest)

Unemployment rate: 11.8 percent

Median home price: $196,000 (55th highest)

Projected to hit lowest level: Q2 2013

Since 2006, home prices in Fort Lauderdale have dropped by nearly 50 percent. A full 28 percent of that drop occurred in 2009 alone. As was the case throughout most of Florida, the collapse of the housing bubble decimated the construction-based economy. The unemployment rate of nearly 12 percent is evident of the construction sector’s disastrous decline. The value of the 686,000 homes in the Fort Lauderdale area is expected to get even worse through at least the second quarter of 2013. Between Q1 2011 and Q1 2012, the median home price is projected to decline an additional 11.1 percent. Between 2012 and 2013, that number will further decrease by 8.7 percent.

9. Bethesda, Md.

Expected price drop: -11.5 percent

Median family income: $114,100 (the highest)

Unemployment rate: 5.1 percent

Median home price: $417,000 (5th highest)

Projected to hit lowest level: Q3 2012

Bethesda, the extremely wealthy D.C. suburb, has the highest median family income in the country — $114,100. It also has the fifth highest median home price, at $417,000. That position may change, however, as Case-Shiller projects home values will drop by more than $60,000 by next year.

8. Salinas, Calif.

Expected price drop: -11.8 percent

Median family income: $62,100 (145th highest)

Unemployment rate: 12.8 percent

Median home price: $240,000 (34th highest)

Projected to hit lowest level: Q2 2012

Salinas is a small coastal city located 25 miles south of San Jose. Since 2006, the median value of the of the 125,000 houses there decreased in value by more than 61 percent. This is the fourth biggest decline from peak home value among all major American cities. More than 40 percent of this drop occurred in 2009, the year after the housing bubble burst. Unemployment in the city is at 12.8 percent, well above the national average of 9.2 percent. Several companies in the area, including food processing company Romco, expect to continue to lay off workers in the coming months, which should serve to further depress home values.

7. El Centro, Calif.

Expected price drop: -12.1 percent

Median family income: $43,300 (10th lowest)

Unemployment rate: 28.6 percent

Median home price: $130,000 (70th lowest)

Projected to hit lowest level: Q1 2012

El Centro is located five miles from the Mexican border, and is one of the poorest cities in the country. Median income is just $43,300 per family, the tenth-lowest in the U.S. Unemployment is at a staggering 28.6 percent. Between 2006 and 2011, home prices decreased by more than 50 percent. According to a report in the Imperial Valley press, one home was sold in the El Centro area before the recession for $390,000. In 2009, that home was listed at $200,000. Prices are expected to drop an additional 12.1 percent by the first quarter of 2012.

6. Miami, Fla.

Expected price drop: -13 percent

Median family income: $47,800 (32nd lowest)

Unemployment rate: 13.4 percent

Median home price: $175,000 (76th highest)

Projected to hit lowest level: Q2 2013

At 13.4 percent, Miami has one of the highest unemployment rates of any major American city. Home values are above average, but are down by more than 50 percent since 2006. Partially as a result of the staggering unemployment rate, the value of the city’s homes are projected to decrease by another 13 percent by the first quarter of 2013. What’s more disturbing, prices will then likely fall an additional 10.1 percent. If this second drop occurs, it will be by far the greatest depreciation of property values in the country in an area already decimated by current low prices.

5. Merced, Calif.

Expected price drop: -13.2 percent

Median family income: $42,900 (8th lowest)

Unemployment rate: 18.6 percent

Median home price: $112,000 (38th lowest)

Projected to hit lowest level: Q2 2012

Merced has a median family income of just $42,900, placing it among the ten poorest major cities in the country. In 2008, the city’s property lost 46.1 percent of its value. This was the second-greatest depreciation in home value for a city since at least 1980. The city’s median home prices are expected to drop an additional 13.2 percent by the beginning of next year.

4. Detroit, Mich,

Expected price drop: -13.4 percent

Median family income: $49,000 (47th lowest)

Unemployment rate: 12.7 percent

Median home price: $42,000 (the lowest median home price)

Projected to hit lowest level: Q2 2012

Since the recession began, Detroit has been the horror story for plummeting home values, foreclosures, vacancies, and unemployment. To date, Detroit’s median home price of $42,000 is the lowest among all 385 major metropolitan areas. While the motor city has been languishing for some time before the recession, the drop in home value has been more steady, as opposed to the rapid drop-offs seen in cities in Florida, Nevada, and California. Detroit’s already record-low values are expected to drop an additional 13.4 percent by the first quarter of 2012.

3. Las Vegas, Nev.

Expected price drop: -13.9 percent

Median family income: $58,900 (196th lowest)

Unemployment rate: 12.4 percent

Median home price: $140,000 (90th lowest)

Projected to hit lowest level: Q4 2012

Las Vegas was one of the center points of the meteoric growth in the first half of the 2000s, only to be followed by a catastrophic fall in the second half. Between 2008 and 2011, home prices in the city dropped by 42.3 percent, the second greatest decline in the country. Although home values in the city are already more than 58 percent off their peak, they are projected by Case-Shiller to drop an additional 13.9 percent by Q1 2012, and then 6.3 percent more by Q1 2013.

2. Riverside-San Bernardino, Calif.

Expected price drop: -15.6 percent

Median family income: $59,700 (190th highest)

Unemployment rate: 13.7 percent

Median home price: $181,000 (70th highest)

Projected to hit lowest level: Q1 2012

Like so many industrial cities in California, Riverside-San Bernadino is being affected by the recession and housing crisis more than most other parts of the U.S. Unemployment has hit 13.7 percent, home vacancy and rental vacancy rates are high, and home values are plummeting. Median home prices are down more than 55 percent from their peak in 2006. By the beginning of next year, prices are expected to drop an additional 15.6 percent, or nearly $30,000.

1. Naples, Fla.

Expected price drop: -16.6 percent

Median family income: $62,800 (137th highest)

Unemployment rate: 10.5 percent

Median home price: $225,000 (40th highest)

Projected to hit lowest level: Q4 2012

Like much of southwest Florida, Naples was one of the fastest-growing communities in the country as it prepared for the millions of baby boomers on the cusp of retirement. When the housing bubble burst, however, the thousands of construction projects for condominiums and retirement communities were halted or lost money, and home values plummeted. From peak home value in 2006, prices dropped by 55 percent. They are expected to keep falling through next year more than any major city in the country. By Q1 2012, home values will drop an additional 16.6 percent, or nearly $40,000.

Regards,

Michael B. Sauter, Douglas A. McIntyre

Michael B. Sauter is research editor of 24/7 Wall Street.

Douglas A. McIntyre is the former Chairman and Chief Executive Officer of On2 Technlologies, a leading video compression company. He was chosen to be one of the members of the inaugural Streaming Media All-Star team, the 25 people who had the most impact on streaming media over the last 10 years. He was also the Publisher of Financial World Magazine from 1983 to 1995. McIntyre has also been President and Chief Executive officer of FutureSource, LLC and President of Switchboard.com, which was, at the time, the 10th most visited website in the US. McIntyre is a magna cum laude graduate from Harvard.

10 Housing Markets That Will Collapse This Year was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

That is the bad news. Now the worse news: Not only are those jobs not coming back, but the construction industry will continue to diminish for the foreseeable future. The real estate glut is not on hold; it is over. Waiting for its return is similar to waiting for next the big surge in typewriters, 35mm cameras, and home phones.

Why are the construction jobs not coming back? There are three main reasons, the first of which is inflation. Decades of credit expansion and the recent printing of money (quantitative easing) have increased the overall volume of our fiat currency: dollars. Therefore, the value of each dollar unit has been reduced, causing prices to rise. This results in increased costs in construction of new homes. Higher new construction costs make staying in and repairing older structures, or renting, more attractive.

The second reason is fuel costs. Living rurally and working in urban areas is becoming very expensive. Reasons one and two will keep an increasing number of younger workers and couples living and renting closer to work. Why take the financial and mobility risks associated with homeownership?

The third reason is we are broke. Who are “we”? Western civilization, comprised mainly of the U.S. and Europe. Consider this…there are gold and silver coins and bullion: actual wealth storage vehicles. There are paper dollars: temporary wealth storage vehicles. And there are also trillions of “dollars” represented as pixels on screens in accounting software programs.

When I say that we are broke it is because I don’t believe those pixel dollars represent anything. All of the wealth supposedly held in those pixels does not exist. It is a classic Ponzi scheme. If you go today and convert your pixels to actual dollars, everything is just fine. But if 10% of us go today and try to convert our pixels into dollars, the banks will shut down…Why? Because the money doesn’t exist. There is no actual wealth stored in any of those pixels.

Spain and Portugal may require financial bailouts in 2011. Part of the fallout from the Greek financial crisis last year was the creation of a eurozone bailout fund of $1.01 trillion. That fund could be used to assist Spain and Portugal if necessary. Where did that $1.01 trillion come from? Was it removed from another sector of Europe’s economy? Supplied in gold bullion to EU headquarters in The Hague? Removed from the savings accounts of earnest Europeans?

No, none of those could supply that amount of wealth. It was simply created by banking and government officials in pixel dollars (euros). It has no actual, tangible value, because it was created out of thin air. One trillion dollars set aside after a series of business meetings, and no individual, company, or government had to contribute one dollar of actual wealth. The pixels in the spreadsheets represent nothing. They serve only to continue the illusion that everything is fine. Everything is not fine. We don’t have the wealth we’ve been lead to believe we have…we are broke.

What does that have to do with construction? Everything. Cities and counties are broke. They cannot afford to borrow more money, and they cannot continue to raise taxes. States cannot afford the programs and pensions that they’ve promised, nor can they raise taxes. Companies cannot afford the pensions and benefits they have promised. They cannot raise prices either, as their customer base is already shrinking due to cost. Families and individuals are struggling to both get out from under mountains of debt and to mesh sharply rising prices into their budgets.

The federal government spent $3.5 billion more per day than it brought in for fiscal year 2010. It is having trouble borrowing money by selling bonds to foreign entities because our current debt makes those bonds much riskier. The Federal Reserve is administering a program of quantitative easing (printing money or just adding pixel dollars) to keep up the appearance that everything is shipshape. What ship? I’ll get back to that. Point being we are broke. There will be no excess income or wealth to support a large-scale residential construction industry in the near future.

The ship, of course, is the Titanic. Imagine that we’ve already hit the iceberg. But…everything seems to be roughly the same, and the ship’s intercom is continually telling us that everything is just fine. Remember the bailouts and the stimulus packages of hundreds of billions, even trillions, of dollars? That was the crew and the first-class passengers casually heading past you to get into the lifeboats. This current financial system will be on the bottom within a decade. And no, there is not going to be a lot of new residential construction during that decade.

We are already well into a global wealth realignment. How is wealth created? Not obtained, but created? Manufacturing is the application of labor to raw materials to make products. The exchange of those products for tangible assets creates wealth. A nation that manufactures and sells abroad is creating and accumulating wealth. The lower, middle, and upper classes of those nations, whether participating directly in manufacturing or not, benefit from that creation of wealth.

Western civilization in general, and the United States in particular, no longer creates wealth; we simply move it back and forth. Usually to the benefit of those who have the capacity to slowly, without causing concern, convert pixels into actual assets (think lifeboats).

But…the curtain is slowly falling away. The sad state of our current financial situation has become too large, and too smelly, to hide. We are broke. No real wealth means no real money and no real credit, and, therefore, no large force of construction workers will be needed. Take a deep breath and figure out what you want to do next. And yes, I am saying that as much to myself as anyone….

My guess is that it will take at least a generation to recover from this financial predicament. All our debts will have to be paid…the debts that your governments have incurred in your name will be paid by you. Believe it. We will have no choice but to live within our reduced means. The options you have today, the programs and support you have today, the retirement that you think you will have tomorrow no longer exist.

China is not going to be a superpower; they already are the superpower. The Chinese are testing a stealth fighter technologically superior to our best fighter, of which we have scant few. When they move to production, they will be able to produce as many as they think they need. We will not keep pace…we are broke. We will lose air superiority in a wide arc around China, including the Koreas, Japan, Taiwan, and the Philippines within five–10 years. The discussion of whether or not we should be the world’s policeman is moot; we can’t be.

We have to pay our debts, live within our means, roll up our sleeves, and get back to turning raw materials into products with efficient labor. Government’s restrictions and regulations concerning manufacturing will begin to ease…they will have no choice. We as a nation will eventually emerge stronger and more compact. We as individuals will be greatly challenged, but we will be fine, if not finer.

There is no need for panic or despair, no matter what the news brings in the near future. Take this period of relative calm to sharpen your tools, mend your work clothes, and trim the fat out of your budget. We’ll all be back to work shortly, and no doubt working our butts off at something we’d never expect today…

Regards,
Jim Kearns
Rustic Structures
Whiskey & Gunpowder

February 9, 2011

A Self-Employed Carpenter’s Thoughts on the Future was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Krugman also poses questions concerning (price) inflation rates and the connection between nominal and real GDP. But I think he is conflating the Austrian theory with a purely “real” business-cycle theory. Austrians understand that monetary influences can have real effects. To repeat, that is the very essence of the Mises-Hayek theory.

Although most of Krugman’s objections are due to his unfamiliarity with the actual Austrian theory, I think one source of confusion came from the particular illustration I used in my article. First let’s set the context by quoting Krugman:

“So what is the essence of this Austrian story? Basically, it says that what we call an economic boom is actually something like China’s disastrous Great Leap Forward, which led to a temporary surge in consumption but only at the expense of degradation of the country’s underlying productive capacity. And the unemployment that follows is a result of that degradation: there’s simply nothing useful for the unemployed workers to do.

“I like this story, and there are probably other cases besides China 1958–1961 to which it applies. But what reason do we have to think that it has anything to do with the business cycles we actually see in market economies?”

First, I should say I’m glad that Krugman at least concedes that (his understanding of) the Austrian explanation both is theoretically possible and actually happens in the real world — coming from the guy who referred to it in 1998 as equivalent to the “phlogiston theory of fire,” this is progress!

However, Krugman still doesn’t have quite the right understanding of the Austrian view of the “capital consumption” that occurs during the unsustainable boom. As I said above, on this particular issue the fault lies with the necessarily simplistic “sushi model” I used in the article that Krugman read.

In that article, in order to make sure the reader really saw why Krugman (and Tyler Cowen) were overlooking something basic, I had the villagers boost their daily sushi intake even while they developed a new technology to help augment their fishing. So during their “boom,” it would have seemed to a dull villager that both consumption and investment were rising.

In my fable, this was physically possible because the villagers neglected the regular maintenance of their boats and nets. This neglect wouldn’t show up overnight, but eventually the village economy would crash. To repeat, I chose this illustration to make basic points about the capital structure and how short-term consumption binges can be physically possible, but must still be “paid for” in the long run.

Unfortunately, my fable and the lessons I drew from it gave the impression (see Tyler Cowen’s critique) that the Austrians think the “capital consumption” during the unsustainable boom period must show up in things like reduced spending on building maintenance, or perhaps in the owner of a fleet of trucks neglecting to have the tires rotated.

In reality, it’s more accurate to say that during the boom period, entrepreneurs (led by false signals) invest in projects that are individually rational and “efficient,” but that don’t mesh with each other. In other words, it’s not so much that a farmer forgets to plant some of the seed corn in order to have a future crop. Rather, it’s that a farmer plans on expanding his output, and so he plants much more than he did in the past, but unbeknownst to him, the owners of the silos and railroads (needed to bring the harvest to market) aren’t expanding their own operations at the same pace.

In summary, it’s not that the Austrians think an inspection of an individual enterprise will reveal a technological deficiency. Rather, it’s that all of the entrepreneurs are “getting ahead of themselves,” trying to develop too quickly. There aren’t enough real savings to allow all of the new processes to be completed. To capture this aspect of the Austrian theory, Mises’s analogy of a homebuilder (who draws up blueprints thinking he has more bricks than he really does) is still the best.

Krugman Wants to Know: Where’s the Evidence?

This leads into Krugman’s central complaint:

“Oh, and what evidence is there that the economy’s capacity is damaged during booms? Investment rises, not falls, during booms; yes, I know that Austrians take refuge in cosmic talk about the complexity of production and how measured investment may not show what’s really happening, etc., but where’s the positive evidence of what they’re claiming?”

I can sympathize with Krugman, but there is no simple statistic to which we can point. Austrians are correct to say that “measured investment may not show what’s really happening,” and correct to say that production is much more complex than depicted in Krugman’s models. This isn’t “cosmic talk” but a statement of basic facts.

[Robert Murphy’s newest book is Lessons for the Young Economist. Paul Krugman would do very well to read it. You can get your copy today for only $19.96 when you go to our bookstore and apply your 20% discount code. Just click here and don’t forget to enter the code E401M102 to get 20% off your total purchase. — Ed.]

But to answer his question, Austrians certainly can point to positive evidence of their view. For example, Austrians argue that during the housing boom years, Americans didn’t save enough out of their wage and salary income, because they were misled into thinking they were much wealthier than they really were. Then when reality set in the illusion was shattered, and valuations of capital assets fell sharply. Realizing they had made terrible decisions during the boom, Americans sharply increased their savings. The data match this story pretty well:

The above chart shows that the savings rate (blue) plummeted during the peak years of the housing bubble, as the S&P 500 (red) zoomed upward. Then in late 2007 the stock market began crashing, while the savings rate increased very sharply. The stock market turned around in early 2009, of course, but from the Austrian perspective, this is because the Fed’s massive interventions — capped off by the first round of “quantitative easing” (which was announced at this time) — started artificially blowing up asset prices again.

We can also get hard empirical support for the Austrian claim that the housing boom drew an unsustainable amount of real resources (including labor) into that sector, which eventually collapsed and caused a spike in unemployment. The following chart compares total construction employment (blue line) with the home vacancy rate (red line), which is a good indication of a speculative bubble: people were buying homes not to live in, or even to rent out, but to “flip” when the price went up. Notice the connection between the speculative housing bubble and the workers sucked into — and then expelled from — construction:

When it comes to applying the generic Austrian theory to the recent boom-bust cycle, we have to think globally. During the boom, much of the rising stream of consumption goods enjoyed by Americans was physically produced in China and other foreign countries. To put it in terms Krugman will appreciate, we could say that the boom period’s surge in imports (which “subtract” from GDP) was consistent with a “healthy” string of GDP increases, not because of counterbalancing exports, but rather because Americans and their government kept spending more and more each year (thus boosting C, I, and G), more than offsetting the growing trade imbalance.

There is nothing wrong with a trade deficit (or more accurately, a current account deficit) per se; elsewhere I explained how a very healthy and sustainably growing economy could have an indefinite stream of such deficits, as the rest of the world rushed to invest in a country blessed with attractive policies.

But when it comes to the actual housing boom under George W. Bush, Americans’ accumulation of SUVs, plasma-screen TVs, and gaming consoles was clearly unsustainable. This is not because — as in my sushi story — Americans were forgetting to do standard maintenance. Rather, it is because Americans couldn’t possibly have kept “total output” — which is very imperfectly captured in our official GDP figures — at the dizzying height at the end of the boom period, because it required foreign producers to continue sending us goodies in exchange for ownership claims on a growing collection of McMansions in which nobody could afford to live.

To make sure that this intuitive story fits the facts, we can chart an index of home prices (blue) against the current account balance (red). The figure below illustrates quite nicely that as the housing bubble inflated, the current account sank more deeply negative. Then the housing bubble and the trade deficit both began collapsing at roughly the same period, as American consumers (and foreign investors) came to their senses.

Of course, Krugman’s models and interpretation can incorporate the above evidence too. So he could understandably claim that he has no reason to credit the Austrian view over his own.

But I can point to at least two episodes where the “sectoral-readjustment” story of the Austrians clearly has more explanatory power than Krugman’s “insufficient demand” story. Specifically, in late 2008 Krugman argued that the housing bust had little to do with the recession, because the latest BLS figures showed that unemployment at the state level bore little relationship to the declines in home prices across the states.

However, I pointed out that looking at year-over-year changes in unemployment at the end of 2008 was hardly the right test. If we looked at changes from the moment the housing bubble burst, then five of the six states with the biggest housing declines were also in the list of the six states with the biggest increases in unemployment.

On another occasion (last summer), Krugman once again thought he had dealt the readjustment story a crushing blow when he pointed out that manufacturing had lost more jobs than construction. I pointed out that this too wasn’t a valid test, because manufacturing had more workers to begin with. When we looked at percentage declines, then construction did indeed crash more heavily than manufacturing. Furthermore — and just as Austrian theory predicts — the employment decline in durable-goods manufacturing was worse than in nondurable-goods manufacturing, while the decline in the retail sector was lighter than in the other three.

These are very important episodes. When Krugman thought the numbers were on his side, he was happy to cast aspersions on the sectoral-readjustment story; he thought his own model was perfectly able to explain the situation if the crash in housing really didn’t have much to do with the upheaval in the labor markets. And, as Krugman himself argued, had he been using valid tests, then the outcomes would indeed have been challenging to the Austrian story.

So now that we see the changes in employment really do match up with the Austrian explanation, we should be much more confident that it is capturing at least an important part of the story. To repeat, I didn’t set out to find data that matched the Misesian exposition and then finally settled on some charts that did the trick. Rather, Krugman thought he had found a falsification of the theory, but it turned out he had conducted a poor experiment.

Because Krugman was the one who set up these two challenges, it is significant that the Austrian theory passed with flying colors. Furthermore, it is significant that Krugman’s own theory cannot explain the actual sectoral shifts in the labor markets. Remember, Krugman wasn’t at all embarrassed by the data when he (erroneously) thought the housing bubble had little to do with the unemployment problem.

This is very important, because it was Krugman who notoriously advocated (in 2002) and then defended (with caveats in 2006) the creation of a housing bubble.

I am not engaging in a character attack or “gotcha” by pointing this out: it is very significant that Krugman’s model prescribed a housing bubble as a solution to the dotcom crash, even though — as we’ve seen — Krugman’s model is obviously inferior to the Austrian explanation when it comes to assessing the fallout from the housing bubble.

Conclusion

I do not claim that the Austrian theory of the business cycle captures every pertinent feature of modern recessions. What I do claim is that a theory — including any of Paul Krugman’s Keynesian models — that neglects the distortion of the capital structure during boom periods cannot possibly hope to accurately prescribe policy solutions after a crash.

Regards,
Robert P. Murphy
Whiskey & Gunpowder

February 2, 2011

Answering Krugman on Austrian Economic Theory was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

According to a recent article in the Baltimore Sun rents are up more than 6% over what they were last year in the Baltimore metro area. If you count the drop in various concessions — like waived application fees or initial free rent — then the increase is even more.

There is a drag on the rental market, however: the regretful buyers who now need to rent out the homes they can’t sell.

Lois Foster, a Baltimore real estate agent who helps people find homes to rent and manages properties for owners-turned-landlords, said she’s seeing rents of $200 to $500 less a month than owners could have gotten two or three years ago. There’s just a lot of competition, she said.

The gild is off the buying lily. All the credit that oozed out of the banks found its way into the national psyche. There it gave off a funny smelling gas that puffed up hopes and dizzied senses.

Stock prices were the first beneficiaries. Fattening 401(k)s danced 1920’s-style energetic jigs with dreams of early retirement. Even as those 401(k)s and those hopes tired and finally dropped dead on the dance floor, the Fed held down interest rates and more funny air kept the nation high. People pinned new hopes on — and sent reams of borrowed new money into — real estate.

That’s come to the sort of end you’d expect. While government cheerleading and easy credit drew in increasing numbers of bigger fools, the rental market found itself a lot emptier. All the people who really couldn’t afford to buy and who should have been renting were too busy buying on greater margins and not renting.

Some hotspot cities like New York and Boston saw their rental markets surging along with their real estate markets…but third-stringers like Baltimore… “Cohan, with Southern Management, said some competitors were offering as much as three to four months of free rent to get people in the door in 2008 and 2009. Not anymore.”

It’s no wonder that they were having such a hard time. The real estate market started to crater in 2006, but the ship of public opinion doesn’t exactly turn on a dime. You don’t undo nearly a century of brainwashing at the start of a downturn. By 2008 and 2009, renters were still considered to be socially backward and intellectually impaired…maybe even in need of corrective medication.

Upon finding out that a person was renting, someone else was likely to voice sincere worry: “What’s wrong with him? Is he marginally employed? Illiterate? Dead?”

Being a renter was worse than gauche. For men it was worse than driving a beaten up old car. Even $7-an-hour female filing clerks were all getting mortgage approvals for $200,000 homes. Any man who couldn’t (or wouldn’t) score a mortgage was parading his lack of fitness to breed. To rent instead of own was to advertise your status as a loser, not the kind of sire any sensible woman would settle for. Your only hope was to troll among hipsters and other car-less, urban trash. A corpse could get a mortgage, but a renter couldn’t get a date.

But now opinions are changing, as they must. Reality can only be ignored for so long. According to a 2010 study o the Joint Center for Housing Studies of Harvard University, between 2004 and 2009, the number of renter households rose nearly 10%.

From the article “The Echo Boom: A New Wave of Market Change” on Wrightwood.com (emphases mine)…

Certainly, most young people rent apartments in their first years out of college, but there are reasons to believe that this generation will be renting far longer than their parents did.  They have the largest college debt load in history – averaging over $20,000 per student.  They also face a very different labor market from their parents: a fifth of them will likely be self-employed following the trend for all employers to offer more and more short-term contracts.  Renting may make economic sense, not just when they are beginning their careers, but for many more years to come. Since the end of World War II, the trend was for more and more young families to purchase a home in the suburbs, leaving rental apartments to young singles.  Based on the economics today, that trend may shift towards renting throughout their lives.

And from a July, 2010, article “Rise of the Renting Class”…

In May, U.S. Housing and Urban Development Secretary Shaun Donovan testified before a House committee that the financial crisis proved the need for a better balance between ownership and rental housing. And HUD senior official Raphael Bostic last week told the Washington Post: “In previous eras, we haven’t seen people question whether homeownership was the right decision. It was just assumed that’s where you want to go,” Bostic said. “You’re not going to hear us say that.”

Left to its own devices, the market pretty efficiently figures out who ought to own and who ought to rent. Those who can afford to do so buy a home because under normal circumstances, buying a home is not any more of an investment than renting one.

So the policies from DC that got their start under that busybody Herbert Hoover to “encourage” homeownership were never a good idea.

The article continues…

Hoover signed the Federal Home Loan Act, and in 1933, Franklin D. Roosevelt created the Home Owners’ Loan Corporation to provide low interest loans.

And the government was just getting started: a flurry of legislation was passed over the ensuing decades, helping veterans, minorities and the populace as a whole secure mortgages. But it appears the pendulum has swung.

“The government shouldn’t blindly encourage homeownership,” says Joe Gyourko, real estate finance professor at University of Pennsylvania’s Wharton School. “If the government does anything the government should encourage people to make the right decision.”

Owners don’t pay the landlord, but they pay taxes and maintenance costs on their house, and Gyourko says those costs can end up being roughly the same.

As far as buying a house as a smart long-term investment, Gyourko says that’s not always true. He says between 1975 and 2008, the price for houses of similar quality and size appreciated an average of about 1% per year after inflation. Investors could have earned more by buying Treasury bills.

Turns out that under most circumstances, homeownership is just another form of consumption. You need a place to live. So you can pay rent, out of which the landlord collects some small profit after mortgage, taxes and maintenance…or you can “buy” your house, or more accurately saddle yourself with debt and pay the mortgage, taxes and maintenance yourself.

But when you have meddling federal policies to encourage it…coupled with ever-increasing amounts of central bank credit to fuel the bidding…prices tend to rise enough to make generations sing in unison “housing always goes up!”

It took generations for this debt-addled Ponzi scheme to collapse; years of government meddling finally coupled furiously with easy credit from the central bank. The result is a veritable orgasm of tumbling prices. We’re in the shame and regret phase that follows these sorts of things. Stay tuned for more.

So as house prices start to reflect how little credit is available to buy house, then buying a house starts to look like a good buy.

Houses are still real things with great utility. They’re bad buys when they’re the objects of debt-fueled speculative mania…but they are still real assets, the sort of things that maintain their value as paper money goes to its intrinsic value.

As we’ve said in these pages many times before, however, you may want to be careful exactly where you buy.

Auto-suburbia is losing its utility and its desirability. More from “The Echo Boom: A New Wave of Market Change”:

One overlooked issue in particular about the Echo Boomers will have a meaningful impact on all forms of real estate…they don’t drive.  According to a report by Kiplinger, motorists aged 21 to 30 now account for 14% of miles driven, down from 21% in 1995.  As quoted in that report, William Draves, president of Learning Resources Network pointed out, “This generation focuses its buying on computers, BlackBerrys, music and software and views commuting a few hours by car a huge productivity waste when they can work using PDAs while taking the bus and train.”

This certainly doesn’t bode well for the automotive industry, but it also may not help real estate strategies that rely on communities and suburbs that can only be navigated by car.  The Baby Boomers fueled the growth of cities that revolve around cars, but the Echo Boomers are likely to flock to places where they don’t have to drive every day.  This could be a significant drag on low-density communities without mass transit and a boon to older, more compact cities.  The exurbs don’t hold as much attraction for this new generation as they did their parents.

Few emergent trends to keep in mind when making investment decisions:

• There are a lot of them – over 80 million people that have to live, work and play in some form of real estate,

• They are gravitating to urban centers even more than their parents,

• They are more plugged into the Internet and social networking than anyone before,

• They are renters, and

• They don’t drive.

I wouldn’t go run to buy up all those abandoned subdivisions that sprung up in the cornfields.

The baby boomers will scratch their heads at that one. There may even be a snort of derision or two from that crowd. Suburbia and exurbia is all that they’ve ever known.

I’d go with productive farmland…or housing that doesn’t require a car. You know: the old downtown that used to be built before the government threw its weight behind the growth of automobile suburbia.

Sincerely,
Gary Gibson
Managing Editor, Whiskey & Gunpowder

January 5, 2011

Forget Buying in the Suburbs and Go Rent in the City was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

But the investment seasons turn. Today some smart investors are once again saying you should a buy house. John Paulson is one of them.

You may know him as the man who turned the greatest trade of all time. Betting against the housing market, he netted a cool billion dollars for himself in 2007. One fund he managed rose 590% that year. Today, he is one of the richest men in America.

His advice today is very different. “If you don’t own a home, buy one,” Paulson said. “If you own one home, buy another one, and if you own two homes, buy a third and lend your relatives the money to buy a home.”

That’s a strong endorsement. It sounds similar to the advice another investor gave his audience in 1971, at the dawn of another inflationary age. It was Adam Smith (George Goodman) on The Dick Cavett Show. Here is a snippet from that conversation:

Smith: The best investment you can make is a house. That one is easy.

Cavett: A house? We were talking about the stock market. Investments…

Smith: You asked me the best investment. There are always individual stocks that will go up more, but you don’t want to give tips on a television show. For most people, the best investment is a house.

Cavett: I already own a house. Now what?

Smith: Buy another one.

It was good advice. In the 1970s, U.S. stocks returned about 5% annually, which failed to keep pace with inflation. Still, it was an up-and-down ride. In 1974, the stock market fell 49%. But here are the average selling prices for existing homes in the 1970s as inflation heated up:

• 1972   —   $30,000

• 1973   —   $32,900

• 1974   —   $35,800

• 1975   —   $39,000

• 1976   —   $42,200

• 1977   —   $47,900

• 1978   —   $55,500

• 1979   —   $64,200

You can see that housing held up pretty well. And think about the effect of a mortgage on 80% of that house in 1972. That would mean $6,000 in equity, a sum that went up fivefold in eight years. It’s hard to find a better inflation fighter than that. Granted, today’s market is different, but still.

Apart from this, you might also reflect on the fact that it is quite absurd today to think that anyone can buy an average house for any of these prices — and that, too, is the point. The average price today is $257,500 — even after the great collapse in the last few years.

“If you have a 7% mortgage and your house is worth half a million dollars,” Adam Smith writes, “you may gripe about shoes and lamb chops and tuitions like everybody else, but your heart isn’t in it.” Your heart won’t be in it because you’ll be in fine fettle with your house.

Of course, you can do a lot better than 7% today. For the first time, the rate on 30-year mortgages slipped below that on the 30-year Treasury bond. You can get a 30-year mortgage at little more than 4% today.

Factoring in mortgage rates, housing affordability is back to where it was in September 1996. Then mortgage rates were 8% and the average price of a home was $171,600. As Murray Stahl writes: “One can actually buy a home for a monthly payment that is not very many dollars different from the monthly payment one would have needed in September 1996, when rates were significantly higher.”

Adjusted for inflation, Stahl points out that the payment for an average-priced home today is about 30% lower than it was 14 years ago.

The advice of Paulson and Smith starts to make sense now, doesn’t it?

Essentially, real estate is a way to buy now and pay later. It is a way to short (or bet against) the dollar. And the case for housing extends to other property types, too. Owners of quality real estate are getting deals on mortgages that we are unlikely to see for a generation.

Regards,
Chris Mayer
Whiskey & Gunpowder

January 5, 2011

Cheap Houses Hedge Inflation Risk was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Already large unions in the U.S are encouraging borrowers to challenge banks to prove they won your mortgage. They’ve set up a website asking the question, “Where’s your note?”

You can see where this is headed. No one in America wants to own a failure. The banks want to foreclose on homes and sell them and avoid taking losses. Borrowers (some of them, and some of them rightly) want to avoid paying a debt for an asset that’s worth less. No one wants to be responsible anymore because the most lucrative and least painful route is to abandon responsibility and your word.

This is a serious breakdown in one of the most basic elements of a functioning market: contract (doing what you said you’d do). People at every level appear to have cheated and lied during the housing boom. The borrowers who lied on their loan applications…the mortgage originators who made the loan without any documentation of work or income…the securitiser who packaged it up and sold it to investors…the ratings agency that rated the debt investment-grade…the insurance companies who sold default insurance against the bonds multiple times…and the government that encouraged home-ownership and subsidised the fraud with an implied guarantee on the bonds of Fannie Mae and Freddie Mac, the government-sponsored enterprises that bought a lot of the garbage bonds.

What is really at stake though?

Well, if borrowers challenge foreclosure proceedings, and if banks (as they have already begun to do) halt foreclosure proceedings nationwide, the process of establishing a market-clearing price in the U.S. house market is frozen. Buyers can’t buy and sellers can’t sell if the ownership of the underlying collateral — the house itself — is in doubt. What sane person would enter a market like this with prices effectively having completely broken down?

As if that’s not bad enough — and it’s nearly as bad as it gets — don’t forget that that there is a whole universe of financial instruments whose value derives from the underlying collateral. Mortgage backed securities…collateralised debt obligations…the value of any instrument whose value is derived from the underlying asset is now suddenly in doubt.

It’s hard to understate what this could mean for financial markets. It could mean another capital crisis in the financial world. It would make 2008 look quaint.

This is why this problem is rapidly escalating into another contest between the banks and the borrowers. The U.S. Congress chose to side with the banks by passing a law (H.R. 3808) which would have made it easier for the banks to foreclose on properties without having to go through the usual process of documentation. But U.S. President Obama — less than a month away from an election that’s become a referendum on his policies — simply ignored the resolution (a pocket veto). Who wants to be seen siding with bankers right now?

Now you have a situation where U.S. banks again face massive losses on their exposure to residential real estate. You have a growing popular movement to challenge the banks through the legal system — raising bank costs and eating into bank earnings (which are already pretty flimsy when you take away the boost to the net interest margin from low short-term rates).

But the biggest problem by far is that you have a growing ethos in the American mortgage market that everything is so upside down and backwards that the best thing to do is just stop playing by the rules and stop paying your mortgage. The whole market is on the verge of breaking down. Trust has evaporated. The rule of law itself now seems irrelevant.

Who is the government going to side with in this dispute? The banks, who will claim (perhaps correctly) that the crisis threatens their ability to loan, and perhaps their very existence? Or will it choose an increasingly angry populace who doesn’t want to again get sacrificed on the altar of saving the financial system?

Our guess is the government won’t choose either. It will choose both!

The easiest way to deal with debt — if you have no intention of paying and don’t want to inflate it away right away — is to simply repudiate it. A great debt amnesty is required!

Bankers must be allowed to sell everything they don’t want to the government, and probably at a price that suits the bank, even if it wouldn’t be borne by the market. And distressed homeowners must be allowed to refinance at a fixed-rate for 50 years through a government lender that will never foreclose on them, and is probably statutorily prohibited from doing so. No one takes a loss. No one loses a house. Voila!

Of course it can’t work that way. Huge amounts of capital have been misallocated in a credit boom. The recovery begins when the losses are taken and household and corporate balance sheets are returned to sanity. But no one wants to deal with that pain. So insanity ensues and a completely zombified mortgage market looms.

Regards,
Dan Denning
The Daily Reckoning Australia
Whiskey & Gunpowder

October 13, 2010

The American Housing Market Is Headed for Total Destruction was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Bernanke spooked investors in New York when he fronted a group of empty headed Senators in Washington and told them that the future of the U.S. economy was “unusually uncertain.” But in a real boon to those of us looking forward to the inflationary effects of trillions of dollars more in quantitative easing, Bernanke assured the Senators that, “We remain prepared to take further policy actions as needed to foster a return to full utilization of our nation’s productive potential in a context of price stability.”

Can this sort of nonsense really be taken seriously? Unfortunately, we have to take it seriously because it has serious investment consequences.

But how long will it be before most people understand that the Fed, the regulators, and the monetary authorities have no credibility when it comes to: a) understanding what is going on, b) fixing it, c) confessing to their culpability in causing the misallocation of capital and the zombification of large chunks of the global banking sector and generally forcing all of us contemplate their moronic and opaque pablum?

These people really are vandals and thieves. We are encouraged to take them seriously and cede micromanagement of the economy and public life to people who don’t have an entrepreneurial bone in their body. What a big con.

In any event, don’t be fooled by the results of the stress test. Those so-called stress tests for European banks are just as much a whitewash of the real capital inadequacy issues as were the American stress tests. In fact, the whole exercise is perfect pretext for another round of central bank quantitative easing/outright support of asset prices.

After all, American and European banks are stuffed full of housing-backed securities and sovereign debt. The credit boom manifested itself in many assets. Much of the fiscal and monetary policy since 2000 has been designed to keep those assets from deflating. It can’t work.

We reckon this latest and largest round of quantitative easing will come sooner than most people are expecting and be a lot less effective than some people are hoping. It’s time to get ready for it now. Crank up the fan…here comes the merde.

Meanwhile, a minor merde storm is brewing between Australian banks. Nothing sexier than watching the banks go at it over lending practices. Commonwealth Bank of Australia hard man Ralph Norris delivered a rhetorical smash to the nose of NAB’s Mark Joiner. According to the Australian, Joiner said last month that some banks in Australia were making “super profits” by expanding their mortgage lending to the detriment of small business lending.

“Kapow!” says Mr. Norris. Well, not literally. Rather, he said, “I think the real issue is that we have a bank (NAB) that has performed poorly for many years and missed out on an opportunity when the mortgage market opened up… The market [for small business lending] grew by 0.5 per cent and we grew by 9 per cent…I don’t know where that rubbish is coming from, because the facts certainly don’t support it.”

Never having been a banker, we are inclined to sit back and watch the slap fight. But the stakes are high. CBA’s loan book is 60% in residential mortgages. Under Basel II, the bank has to hold less capital against a home loan than it does against a ‘riskier’ business loan. So, you could argue that expansion of the mortgage lending book, even at the expense of business lending, is a safer move for the bank and delivers bigger profits to shareholders. It also keeps the rivers of credit flowing into Australian property.

You could argue that. But it’s not the argument we would make. We would instead make a high-handed, ivory tower, abstract kind of comment that the people of a nation can’t all get rich by buying and selling houses from one another. For one, it’s a singularly unambitious national goal. But that’s not the biggest argument against it.

Creating a profit is hard. In some ways, it’s unnatural. Profit is surplus value. Human beings improve their living standards by increasing productivity and efficiency through innovation and constant adaptation. The free market is a great mechanism for producing surplus, as long as risk taker and small businesspeople and crack pot inventors and dreamers and builders have access to capital. Of course the banks are under no obligation to take bad risks (unless you’re talking about U.S. banks compelled to make loans to bad credit risks during the American housing boom.)

As for the aforementioned impending (we believe) quantitative easing round two, how should you prepare? Well, in the fashion that you find most fit naturally. But we’d suggest that asset markets are going to cop it good and hard in the second half of this year. We’re expecting a one-two combination of big falls in stock markets and then wild, irresponsible, unprecedented and unconventional attempts to reflate by central banks.

Regards,

Dan Denning,
The Daily Reckoning Australia

P.S. In the meantime don’t forget: the people backing an emissions trading scheme the most usually have a vested interest in the exchanges that will be set up to trade said emissions. It’s like a potential casino owner telling you we should all be compelled to gamble. The government’s interest in the matter is self-evident: mo’ money. And the bureaucrats who are backing it presumably thrive, in some small-minded and mean-spirited but satisfying way, on simply telling people what to do.

Resist them all! And as the great thinker, champion of liberty, and emancipated American slave Frederick Douglass advised, “Agitate! Agitate! Agitate!”

Fed Up with the Fed and the Welfare State was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

We just had a week in the 70s, with more to come. The grass went from ochre to bright green in about thirty-six hours. The buds are popping like mad. This is usually what the first week of May is like around here, and that fact alone may explain New York state’s relentless population drain over the past forty years.

I was out on my bicycle, naturally, taking it all in — like, why sit inside and sulk because the weather is strange in a pleasant way? — and I ventured into the outlands east of town, where an impressive number of gigantic new houses had landed like alien mother-ships in the former cow pastures and wood lots. Of course, the aesthetics were an issue apart from the socio-economics of it, but nonetheless interesting.

Each new, gigantic house seemed the result of a losing struggle to reinvent basic design principles that did not require re-invention. I doubt the spirit of joyous “creativity” among the star-architects has seeped down to the level of the provincial house-builders, who, after all, are just assemblers of modular materials like dimensional lumber and eight-foot sheet-rock. It’s their inability to assemble these parts coherently that’s really striking, so what you get is an endless variety of mistakes along with a complete absence of anything done really well — which may be the essence of what the “diversity” craze has really meant to us, the ethos of current times.

The abiding quality of all these houses was grandiosity (by which I do not mean grand-ness). That, too, is a signature of these times in America — the nation too big to fail and tragically destined to do just that on account of its too big to fail-ness. And, of course, one could not fail to wonder, cruising by these hideously ponderous houses, whether as a matter of fact they were failing in terms of the owners’ ability to keep up with the payments, for instance. One after another, I pictured a husband and wife within sitting in the sunny breakfast room on Easter morning humped in tears as they sorted through stacks of bills and bank statements… and I imagined the yellow foreclosure tape a few weeks hence atop the weird split-block portico treatments and misbegotten arrays of concrete balusters, and the colossal Palladianesque windows with their pathetic snap-in muntins (and the fantastic solar heat-gain, not figured-in by the designer-builder, that would turn the lawyer-foyer into something like a crematorium by two p.m.)… and the pension fund in Wisconsin or Norway that was sitting on the booby-trapped CDO that contained this sketchy mortgage and thousands of others just like it… and, well, this choo-choo of thoughts led to envisioning the train-wreck of economies and nations that lies in wait just around the bend….

One also could not fail to reflect on the recklessness of a nation that placed untold million-dollar bets on the idea that it would be possible to travel anywhere in an automobile from houses like these a few scant years from now. This far along in the tribulations of our time, most Americans still have not heard of peak oil, and the few who have regard it as some figment that Ralph Nader or Al Gore conjured up on an acid trip in a sweat lodge.  The more sophisticated among the mentally unwashed are certain that the earth has a creamy nougat center of low-sulfer light crude oil, or they heard that the Bakken formation in Dakota holds more oil than Saudi Arabia, or that the whole US car and truck fleet will be electrified in a year or two, or that we can drill-baby-drill our way to permanent oil abundance, or just that the American can-do spirit will come up with something to keep Happy Motoring alive because we’re the greatest! Such grandiosity!

Personally, I look at these houses scattered around what was only recently a dedicated farm landscape and I am quite sure that the denizens within will be marooned in their great rooms, and that very probably many of them will have no job to go to — in the conventional sense of what we think a job is, in some corporation or institution — and that in a surprisingly short span of years these buildings will be ruins or squats. I think these thoughts after struggling up a rather steep hill more than half-a-mile (and many others previously). A trip anywhere from here, to do anything, and the return trip, would occupy an entire day even for someone in decent physical condition. Somebody accustomed to rations of Cheez Doodles and Mountain Dew would be dead by then. There will be lots of dead.

On the macro level, the feeling spreads across the USA that our troubles are behind us. Employment is ticking up. The S & P index only goes up now. The banks have stabilized and those “toxic assets” (which I call “frauds” and “swindles”) have been disarmed and safely buried under Yucca Mountain. Housing starts may still be weak, but the “gaming” industry is making great strides in places like the old Puritan commonwealth of Massachusetts, so soon we’ll have a virtually automatic economy of leisure-and-entertainment paid for by creaming off a small percentage of the quarters pumped into video slot stations. No doubt the Chinese will be jealous and try to imitate us.

All these lovely mild days, I was not unconscious of the eeriness of the weather and the possible insidious effects of it on the local ecosystem in everything from the added generations of deer ticks carrying Lyme disease and the death of the honeybees to the fate of this year’s apple crop. I confess: it made me very nervous. Something is happening… out there.

Regards,
James Howard Kunstler
Whiskey & Gunpowder

April 6, 2010

P.S.: Click here to listen to my new play Big Slide about life as the long emergency gains traction.

Peak Oil and Unpaid Mortgages Will Kill Suburbia was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Doug: Sure. This is a good time, too, because I’m having a sort of house-warming party at the world-class resort we’re building in Salta province, northwest Argentina. With the stipulation up front that I obviously have a financial interest in that project, I still think that, for a number of reasons we’ll get into, Argentina is simply the best place in the world to weather the economic crisis. Yesterday is not too soon to start working on getting your assets and yourself out of harm’s way.

L: Okay, so let’s start with basics: why Argentina?

Doug: Well, I’ve been to 175 countries, most of them several times. I’ve lived in 12, defined as having spent enough time in the country to have rented a place to live or bought real estate and set up housekeeping. The thing is, technology has now progressed to the point at which any sufficiently motivated person can pretty much live wherever he or she wants. But most people still have a medieval serf mentality in this area, and tend to live in or near the place where they were born and grew up. And they tend to think that the country they were born in is the best country in the world…I guess because they were born there.

L: All evidence to the contrary notwithstanding. And the more poverty-stricken and backward the place, the more fiercely patriotic its inhabitants tend to be. I suspect this is a modern expression of tribalism.

Doug: I’ve noticed that too — you travel now as much as I used to, so I’m not surprised we see most things the same way. But, as you know, I’ve never had a tribal inclination myself. And having been to so many places, seen their pluses and minuses, it’s all the more clear to me how ridiculous it is to see the world that way. Although, it must be said, the tribal way of organizing a society actually makes more sense than the nation state does — at least in a tribe you basically know everybody, typically have a blood or family relation with them, and almost certainly share values. The nation state is just a piece of geography controlled by a central government. This is another subject, for another time, but I believe the nation state is on its way out, and in the process of being replaced by what Neil Stephenson called “phyles” in his seminal book The Diamond Age.

Anyway, I asked myself, “Where is the best place to live, in order to enjoy life to the max, be freest, and enjoy the highest standard of living with the least amount of aggravation?” I looked at all the countries around the world, their pluses and minuses, and came to the conclusion that Argentina offers the best risk/reward and cost/benefit ratios of any country on the planet at this time.

L: Can you tell us more about how you came to that conclusion?

Doug: By a process of elimination. A couple generations ago, if you’d asked me where the best place to live was, I’d have put my finger on the United States. Back when it was still America, it offered a lot of freedom, a lot of opportunity, and had a lot of domestic capital. But things have been changing, and are changing very rapidly in the U.S. now. It’s no longer what it used to be. So the U.S., regrettably, no longer makes the cut — at least not if you have some capital.

L: It’s no longer the land of the free and the home of the brave. It’s become a land of obedient subjects who allow the government’s bread and circuses to distract them from the fact that they have been cowed.

Doug: Sadly so. And Europe is worse. It’s hide-bound, constipated, heavily taxed and regulated, highly socialistic, and is suffering from what may turn into a demographic collapse.

L: My ex was from Germany, and she told me families were basically paid by the government to have children.

Doug: It’s not working; few people are having kids. But there’s massive immigration, primarily from Muslim countries.

L: Those people are often very hard working and entrepreneurial, but they are not assimilating.

Doug: They are not assimilating, and Europe is becoming less European. Worse, the cultural clash could turn into something more serious, given the increasing tension between the West and Islam. The Crusades never really ended — they just seem to have time-outs between rounds.

L: Europe could turn into the battlefield the Cold Warriors feared it might, but in a totally different war.

Doug: Yes. It’s a conflict that goes back to the 8th century, and I don’t think it will be resolved any time soon. So, I’d rule out living in Europe.

L: Africa?

Doug: Completely hopeless for anything other than a hit and run speculation. Too much racism, too many other serious and deeply entrenched problems.

L: And the Orient?

Doug: I’m a big fan of the Orient — I really like it. But frankly, if you’re of European extraction, you can have a great life in the Orient, but you’ll never become part of society there. It’s just not going to happen.

L: Why is that so important? When I moved to Utah, people told me the same thing; the Mormons wouldn’t invite me to their picnics if I didn’t convert. But I didn’t want to go to their picnics. I just wanted to be left alone. I loved it.

Doug: I understand, and value my privacy as well. But I enjoy going out to dinner with good friends at great restaurants. I like playing polo, and that’s not something you can do alone. I like a friendly poker game once in a while. There are many benefits to society, and I enjoy them. But as pleasant and convenient as the Orient is, it’s also pretty crowded; I like wide-open spaces.

L: You just don’t want the cost of participating in society to exceed the benefits.

Doug: As a practical matter, that’s right. There are moral issues as well, but that’s another conversation.

L: Okay. So, eliminating the U.S., Europe, Africa, and Asia leaves Latin America and Down Under.

Doug: Oddly enough, as I speak to you (for free, on Skype — I love technology!), I’m in New Zealand. Rick Rule and I bought a big ranch on the ocean ten years ago, and I also bought a smaller ranch on the Clevedon River. I first came here, as you know from our conversation on the subject, for the polo. It was kind of a joke. People used to ask why I came to New Zealand, and I would say it was for the kangaroos. “But,” people would say, “There are no kangaroos in New Zealand.” “Yeah,” I’d reply, “I was misinformed.” But it was really for the polo.

New Zealand is a delightful place. I think I’ll keep my ranch here, because I like it. But the fact is that, for all of its advantages, New Zealand is an island, and it’s pretty much at the end of the road. It’s not very sophisticated, quite frankly, and it’s become quite expensive.

When I first moved here, and was recommending the place highly in the International Speculator, it was almost as cheap as Argentina is today. It was so cheap buying a meal in a restaurant, you’d almost feel guilty. But since then, the currency has doubled in value and domestic prices have risen more rapidly than in the U.S., so the general cost level is about the same as in the U.S. It’s not a bargain anymore.

That’s even more true for Australia, which is bigger, but isn’t as pleasant, to my way of thinking. Entirely apart from the fact that everything that moves there, on the land or in the sea, tends to be deadly.

L: And that leaves Latin America.

Doug: Exactly. Within that, what do we have? Central America, to be brutally brief, is “okay.” But those countries simply have no class. When it comes to South America, I’m very partial to Argentina, Chile, and Uruguay. Of these, I prefer Argentina. Why? Because it has a down-at- the- heels, but very classy, elegance. That kind of reflects the fact that, a hundred years ago, it was the major competitor to America for the best place to go if you were a European looking to immigrate to the New World. It attracted many of Europe’s best and brightest — and their capital.

Argentina blew it, of course, transforming itself from having one of the highest standards of living in the world to an economic basket case over the course of the 20th century. But in spite of how monumentally stupid the government of Argentina is, with controls and regulations on everything, a big bureaucracy, and so forth, that’s compensated for by the fact that the place is very, very inexpensive. Whether you’re looking at real estate or day-to-day expenses, it’s much cheaper than either Chile or Uruguay. Also, I’ve found that on a practical level, the government leaves you alone more than most.

Uruguay, of course, is just across the Plate River from Argentina. It’s got some advantages, but it’s rather like a backward, yet more expensive, province of Argentina.

L: Why’s that?

Doug: It’s a smaller country than Argentina, one tenth of the size, both in population and land area. It’s long been known as a kind of “Switzerland of South America.” It’s a banking haven. Until recently, there was no income tax in Uruguay. Idiotically, they just slapped one on domestic income, but foreign income is still tax-free there. That draws a lot of rich foreigners, who have a disproportionate effect on prices. They bring a lot of capital, and the country’s currency has risen about 30% against the Argentine peso in the last year. So, it’s nice, but it’s a quiet backwater — except for Punta del Este during January and February, when it’s one of the most hopping places on earth. But Uruguay is considerably more expensive than Argentina at this point.

A lot of Uruguayans, if they’re in a position to, tend to want to live in Buenos Aires instead of Montevideo. Montevideo is a place that still has horse-drawn wagons and gauchos standing around on street corners, drinking mate.

L: And the Graf Spee in the harbor.

Doug: [Laughs] I can’t help but think of that when I’m there. The place is in a time warp, although a lot less than it used to be. When I first went to Argentina, in 1980, I felt I was taking a trip back to the 1950s. Then, when I went across the river to Uruguay, I felt I was taking a trip back to the 1930s. They still had the old black, Bakelite telephones. That’s all changed, but these countries are still caught in a bit of a time warp.

L: And Chile?

Doug: Chile is the unsophisticated mining province that made good… It’s modern, everything works, and the capital city of Santiago is clean and nice, if plagued by air pollution. But it’s a lot more expensive than Argentina or Uruguay, and doesn’t have the same charm. Pinochet, for all his faults, put the place on the road to success. It’s estimated the average Chilean has more net worth than the average American now.

L: So it’s Argentina.

Doug: Yes. For one thing, I like its wide-open spaces. It’s like the western U.S. Argentina is the size of the eastern U.S., but it has only 40 million people, and about 40% of those are centered around Buenos Aires. So, once you get out of BA — which is one of the great cities of the world: sophisticated, marvelous, you can get everything and anything you want there, just one of my favorites — you really are in the countryside. In most places, you can drive for hours through incredible scenery, and not see another car. I like that.

Sometimes people, who haven’t been there, look at me in a questioning way when I mention Argentina, because they’ve heard of the government. But it’s not evil, or dangerous, like many. It’s just corrupt, incompetent, and inefficient — which is actually much better than the alternatives, when we’re talking about governments. But there are disadvantages, too. Through one of the most impressive acts of government stupidity I’ve ever seen, Argentina, a country world-renown for its beef, might actually end up having to import beef this year. It’s insane. Like Saudi Arabia importing oil. But, that’s what governments do.

Still, you can get the best beefsteak in the world for, oh, I would say a sixth of what you’d expect to pay for something equivalent in the U.S.

L: I’ve been to El Rey del Bife in Salta City and verified this for myself. One of the best steak dinners I’ve had, with salad and wine (I’m not religious about avoiding alcohol, and I wanted to try something local), and it was just over five bucks.

Doug: It’s unbelievable. And I think I’ve found a place that’s even better than El Rey del Bife, so we’ll have to go there next time we’re in town together.

L: I’ll look forward to that. Did you start buying land all the way back in 1980, when you first visited?

Doug: No, I bought a ranch in Patagonia about a dozen years ago. One of my best Argentine friends said, “You’ll make some money on that. It’s okay for gringos, but if you really want something special, you’ll go up to Salta province”. I did, and he was quite correct. Patagonia is pretty, but it’s not a center of culture.

L: It’s mostly empty. I’ve been there. I think I saw more penguins than people.

Doug: It’s basically a large expanse of wind-blown desert, except for a narrow band along the border with Chile, which is very pretty.

L: Because of the Andes.

Doug: The mountains, exactly. That’s really it. So it’s quite overrated and over-promoted. Salta, indeed the whole northwest area of Argentina, is much more interesting. Salta, by the way, was recently named in Frommer’s Top Ten Destinations: 2010. I especially like Cafayate, a town about the size of Aspen, Colorado, and strikingly similar in a number of ways. It’s got a beautiful central square, with lots of sidewalk cafes, a couple dozen nice restaurants. It’s very gemutlich, very enjoyable.

L: And it’s not overrun by leftist environmental extremists.

Doug: Definitely one of its great qualities. But as nice as it is, it didn’t have everything I wanted in a place to live. I thought, “Well, I’ll just have to bring the things I want here.” So, some friends and I bought 1500 acres on the edge of town, and we’re building a world-class resort.

We’re very fortunate in that Cafayate is in a wonderful grape-growing region – that’s one of the reasons it has so many nice things. All around the world, places that are good for vineyards are generally very nice places to live, as anyone who’s been to Tuscany or Napa Valley knows. This is very much like that. It’s a bit like Taos, New Mexico, meets Napa-Sonoma, California.

But there wasn’t a polo field, so we’re putting a couple in, in our resort, which is called La Estancia de Cafayate. We’re also putting in 40 miles of hiking, biking and jogging trails, an 18-hole, world-class golf course, tennis courts, a lap pool, a Gold’s-type gymnasium,  and a spa. The clubhouse will have everything from a cigar bar, to a billiards room, to a library, to a bocce ball court, to a quiet place where you can play go or chess. I don’t think we’ve missed a single element, providing what a civilized person could want.  We’ve got about 200 acres of grapes, so all the home owners will get their own allotment of wine. Grapes are very aesthetic, which is the big thing, but we want to keep running costs as close to zero as possible — and they’re a big help.

L: Okay, so be honest with me here. We had a conversation about spas, and you went to great lengths to distinguish between little wanna-be spas, where you can get a massage and they put cucumber slices on your eyes, and a real spa, which is a total living experience that includes diet, education, sports and physical training, as well as the saunas and massages, etc. Are you really going to be able to provide that kind of world-class spa experience?

Doug: Well, slowly, slowly, catchee monkey. So far, about 130 people have bought lots, and about 30 houses are under construction. More will be built over time, and that will get us to the level at which we can sustain a spa such as I described. It’s a software issue. We’ll have the physical facilities soon, but it will take a while to build the clientele that would justify having the people there who would provide the services. My intention is to start next year, hiring a couple Thais, or Filipinos, who are multi-talented. They’ll know how to teach Tai Chi, Qui-Gung, do proper Thai cooking, and give proper massages.

As far as the spa cuisine is concerned, we’re well on our way, because almost everything we’ll eat grows in the valley. A wide variety of fruits and vegetables are being planted on our own land right now. The chickens and the beef and the milk are all local and organic.

With a little bit of luck, we’ll eventually be as good as the Canyon Ranch or the like. You know, it takes a little time to develop the software. But I think it’s very important to have the facilities for a full life. Mens sana in corpore sano, as the Romans said.

L: How much is ready to use?

Doug: We’ve built the golf course and golf club house. The construction of the social clubhouse, gym, tennis courts, etc. should start next month. It should all be pretty well done within a year. By then, there should be 40 or 50 houses built, or under construction, and it will be a delightful place to live.

There’s one really interesting, perhaps unique, thing about this project. I’ve lived in, and been to, a lot of communities around the world, and sometimes you like your neighbors, and sometimes you don’t. It’s the luck of the draw. In Aspen, the chances are that I wouldn’t like them; these days it’s just drawing the wrong crowd, from my point of view. But I like all the folks I’ve met who’ve bought lots at Cafayate and are planning to spend time there. It’s a generally laissez-faire, smart, get-along & go-along crowd, drawn from 14 different countries. It’s really becoming a bit of a Galt’s Gulch.

It’s been a pain, having to build it myself, but there was simply no existing place in the world that I knew of that had everything – or even just most of what I wanted.

One sign of how real this is, is that many of those who’ve bought lots at Estancia de Cafayate are Argentines — which shows that the pricing is right.

L: And they pay cash.

Doug: Everyone pays cash in Argentina. That’s why land prices are real and so low – they are not inflated by borrowed money. There simply is no money to be borrowed for real estate in Argentina. None.

L: And you say Argentina has a very European flavor?

Doug: Yes, at this point, Argentina is more European than Europe is. You know what they say: an Argentine is an Italian who speaks Spanish, thinks he’s British, and lives in a French house. That last refers to the gilded age buildings, of which there are thousands. Apartment buildings in La Recoleta generally have 14-foot ceilings and walls two feet thick, because that’s how they were made, back in the day.

You know, I talk about how bureaucratic and stupid the government is, but I think there’s a chance that the place will reform for the better, much the way New Zealand did in the mid-1980s. In other words, you can be so stupid, for so long, that eventually you have to throw in the towel and try being less stupid. There are several candidates running in the next presidential election, which will take place in 2011, who are reasonably market-oriented. If the same thing happens in Argentina as happened in New Zealand in the 1980s, it will boom.

L: With clear consequences for Argentine real estate.

Doug: Exactly, although the place has always had wild fluctuations in prices. When I was first there, BA was more expensive than London. Before the last crisis it was about like New York. Argentina suits me as a speculator, it suits me as a freedom-lover, and it suits me as a place to live. All things considered, of all the countries in the world, I honestly just can’t think of a better one.

And if you want to live there, they are very mellow about it. You don’t need some sort of residence permit. For years, the practice has been to let anyone in for three months, and if you overstayed your tourist visa, even by a couple of years, you only pay a fifty peso fine. And you can come right back in again. Try that in the US and see what happens…

L: What if I wanted to stay more than three months?

Doug: You just take a boat over to Montevideo, get your passport stamped, and come back. Or maybe drive up to Bolivia, or across the mountains into Chile, or maybe Paraguay for a weekend trip. This can be, and is done indefinitely, with no problem. Cafayate actually isn’t a bad place from which to get to know the southern half of the continent. But I don’t like to leave once I’m there.

L: Okay, so it’s no problem to prolong a tourist status, but if for some reason, I wanted to acquire a more permanent residency status, would it be difficult, or expensive?

Doug: No, but you’d be wiser to do it in Uruguay. As an Uruguayan, you can cross over to Argentina with much more ease than even Canadians used to be able to cross over into the United States. They are both Merco-Sur countries, and residents of those countries can move between them freely. You can become a citizen of Uruguay after only two years — it’s not as good a passport to travel on as an Argentine one, but that’s the way to do it.

I should also remind our readers that they don’t want to keep any money in a bank account in Argentina. It’s not a good place for that, but bank accounts and real estate are two totally different things.

L: Anything else? More investment implications?

Doug: I think what’s going to happen, given the demographics we spoke of in Europe, is that thousands and thousands of Europeans are going to come to Argentina. Not poor ones, the kind who immigrated a hundred years ago, but wealthy ones. They’ll see that the lifestyle is better in Argentina. It’s less crowded and vastly cheaper — maybe 20%, or less, of the cost of living in Europe. And they can live there tax-free. As more and more Europeans discover this, you’re going to have a lot more of them piling in. This is going to happen with Americans too, though they won’t gain the same tax advantages. The IRS will still want to tax them; nevertheless, I think we’ll see more of them moving down there. It’s very popular with Canadians as well.

With the good things happening in Colombia, Brazil having finally turned the corner, and the problems clowns like Chavez in Venezuela are running into, there’s a chance that South America, in general, could be the next sleeper that may soon awake to its day in the sun.

So, it’s a place with a future. And any person who does not diversify his or her assets and physical presence, geographically and politically, in today’s world is a fool. If they see what we see and don’t take action, they’ll get what they deserve.

It’s especially important for U.S. persons to do this now, before we see foreign exchange controls in the U.S. making it impossible, or very costly, to get your wealth out of the country.

L: What’s the first step, for someone who hasn’t really thought about these things seriously before?

Doug: I’d like to urge anyone reading this to join me, and my friends, at the open house we’re having at Estancia de Cafayate from March 25 to 28. It’ll be a great introduction to Argentina. Just be warned that you may not want to leave; it’s that pleasant. And late March is a good time to leave the tail end of Northern Hemisphere winter behind. Also, most of the Casey group is going to be there, and we’re going to have a half-day investment seminar for those who come down.

L: That’s what I’ll be doing: hitting BA, then setting out to look for opportunities to invest in gold and silver projects in South America.

Doug: I’ll enjoy seeing you there, and given the type of person who will actually take my advice on diversifying his or her assets out of their home country and come check Argentina out, I’m sure I’ll enjoy seeing them, too. I hope a few of our new readers come on down.

Doug Casey, Casey Research
for Whiskey & Gunpowder

March 16, 2010

Argentina Is the Best Place in the World was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

My interest in Andy was due to the fact that he has been singularly successful in pretty much all aspects of the real estate market, including financing and developing large projects — such as shopping centers, apartment communities, office buildings, and warehouses — from one end of the country to the other. His expertise has also allowed him to build an impressive business providing assistance to large financial institutions that need help in dealing with problem commercial real estate loans. As you might suspect, business is booming.

Back in 2007, however, what most intrigued me about Andy was that he had been almost alone among his peer group in foreseeing the coming end of the real estate bubble, and in liquidating essentially all of his considerable portfolio of projects near the top. There are people that think they know what’s going on, and those who actually know — Andy very much belongs in the latter category.

In fact, he initially refused to speak at our event, only agreeing very reluctantly after I had hounded him for several months. The reason for his refusal, I later found out, was that he had spoken at several industry events before the real estate collapse and had been all but booed off the stage for his dire outlook.

The happy ending of this story is that Andy’s speech at our Summit was a rousing success, and he enjoyed it so much that he has now spoken at several, and has kindly agreed to sit for periodic interviews to keep our readers up to date on the latest developments in this critical sector. So far, Andy’s real estate forecasts continue to come true. 

As you’ll read in the following excerpt from my latest interview with Andy, who now spends considerable time each day helping the nation’s biggest banks cope with growing stacks of problem loans, he remains deeply concerned about the outlook for real estate.

David Galland

No one has been more right on the housing market in recent years. So, what’s coming next? Some of the housing numbers in the last few months look a little less ugly. Could housing be getting ready to get well?

MILLER: I don’t think so.

For all intents and purposes, the United States home mortgage market has been nationalized without anybody noticing. Last September, reportedly over 95% of all new loans for single-family homes in the U.S. were made with federal assistance, either through Fannie Mae and the implied guarantee, or Freddie Mac, or through the FHA.

If it’s true that most of the financing in the single-family home market is being facilitated by government guarantees, that should make everybody very, very concerned. If government support goes away, and it will go away, where will that leave the home market? It leaves you with a catastrophe, because private lenders for single-family homes are nervous. Lenders that are still lending are reverting to 75% to 80% loan to value. But that doesn’t help a homeowner whose property is worth less than the mortgage. So when the supply of government-facilitated loans dries up, it’s going to put the home market in a very, very bad place. 

Why am I so certain that the federal government will have to cut back on its lending? Because most of the financing is done via the bond market, through Ginnie Mae or other government agencies. And the numbers are so big that eventually the bond market is going to gag on the government-sponsored paper.

The public doesn’t have any idea of the scale of the guarantees the government is taking on through Fannie, Freddie, and FHA. It’s huge. If people understood what the federal government has done and subjected the taxpayers to, there would be a public outrage. But you can’t get people to focus on it, and it’s very esoteric, it’s very hard to understand. But it’s not something the bond market won’t notice. The government can’t keep doing what it has been doing to support mortgage lending without pushing interest rates way up.

Refinancings of single-family homes are very interest-rate sensitive. Consumers have their backs against the wall. They have too much debt. Refinancing their maturing mortgages or their adjustable-rate mortgages is very problematic if rates go up, but that’s exactly where they’re headed. So anyone who’s comforted by current statistics on single-family homes should look beyond the data and into the dynamics of the market. What they’ll find is very alarming.   

On that topic, recent data I saw was that something like 24% of the loans FHA backed in 2007 are now in default, and for those generated in 2008, 20% are in default, and the FHA is out of money.

MILLER: Fannie Mae had a $19 billion loss for the third quarter of 2009, and they are now drawing on their facility with the U.S. Treasury. We have all forgotten that Fannie and Freddie are still being operated under a federal conservatorship. On Christmas Eve, the agency announced that they were going to remove all the caps on the agencies.

So what about commercial real estate?

MILLER: When I saw what was happening in the housing market, I liquidated all my multifamily apartments, shopping centers, and office buildings. I liquidated all my loan portfolios, and I’m happy I did.

Then it occurred to me in 2005 and 2006 that the commercial world had to follow suit. Why? Because it’s a normal progression. Obviously, when single-family homes decline in value, multifamily apartments decline in value. And when consumers hit the wall with spending and debt, that’s going to have an impact on retailers that pay for commercial space.

Furthermore, the financing for retail properties had gotten ludicrous. The conduits were making loans that they advertised as 80% of property value when they originated them, but in reality the loan-to-value ratios were well over 100%. And I say that to you with absolute, categorical certainty, because I was a seller and nobody knew the value of the properties that I was selling better than I did. I had operated some of them for 20 years, so I knew exactly what they were bringing in. I knew what the operating expenses were, and I knew what the cap rates were. And, you know, the underwriting on the loan side and the purchasing side of these assets was completely insane. It was ludicrous. It did not reflect at all what the conduits thought they were doing. They were valuing the properties way too aggressively.

I became very bearish about the commercial business starting in late ‘05. In fact, I think I was in Argentina with Doug Casey, sitting on a veranda at one of the estancias, and he and I were lamenting what was going on in the real estate business, and I said there was going to be a huge adjustment in the commercial market.

Beyond the obvious, that the real estate market has taken pretty significant hits and some banks have been dragged under by their bad loans, what has really changed in real estate since the crash? 

MILLER: I think the first thing that changed was that people learned that prices don’t go up forever. Lenders also saw that underwriting guidelines for commercial real estate loans, especially in the securitization markets, were erroneous. They realized that some of their properties had been financed too aggressively, but still, I don’t think even at the fall of Lehman, anybody was predicting a wholesale collapse in commercial real estate.

But they did see they should be more circumspect with loan underwritings. In fact, after the fall of Lehman, they completely stopped lending. I think they realized we had been living in fantasy land for 10 years. And that was the first change — a mental adjustment from Alice in Wonderland to reality. 

Today it’s clear that commercial properties are not performing and that values have gone down, although I’ve got to tell you, the denial is still widespread, particularly in the United States and on the part of lenders sitting on and servicing all these real estate portfolios. People still do not understand how grave this is.

Right now there are an awful lot of banks that do an awful lot of commercial real estate lending, and for about a year now you’ve been telling me that you saw the first and second quarter of 2010 as being particularly risky for commercial real estate. Why this year, and what do you see happening with these loans and the banks holding them?

MILLER: It’s an educated guess, and it hasn’t changed. I still think that it’s second quarter 2010.

The current volume of defaults is already alarming. And the volume of commercial real estate defaults is growing every month. That can only keep going for so long, and then you hit a breaking point, which I believe will come sometime in 2010. When you hit that breaking point, unless there’s some alternative in place, it’s going to be a very hideous picture for the bond market and the banking system.

The reason I say second quarter 2010 is a guess is that the Treasury Department, the Federal Reserve, and the FDIC can influence how fast the crisis unfolds. I think they can have an impact on the severity of the crisis as well – not making it less severe but making it more severe. I will get to that in a minute. But they can influence the speed with which it all unfolds, and I’ll give you an example.

In November, the FDIC circulated new guidelines for bank regulators to streamline and standardize the way banks are examined. One standout feature is that as long as a bank has evaluated the borrower and the asset behind a loan, if they are convinced the borrower can repay the loan, even if they go into a workout with the borrower, the bank does not have to reserve for the loan. The bank doesn’t have to take any hit against its capital, so if the collateral all of a sudden sinks to 50% of the loan balance, the bank still does not have to take any sort of write-down. That obviously allows banks to just sit on weak assets instead of liquidating them or trying to raise more capital.

That’s very significant. It means the FDIC and the Treasury Department have decided that rather than see 1,000 or 2,000 banks go under and then create another RTC to sift through all the bad assets, they’ll let the banking system warehouse the bad assets. Their plan is to leave the assets in place, and then, when the market changes, let the banks deal with them. Now, that’s horribly destructive.

Just to be clear on this, let’s say I own an apartment building and I’ve been making my payments, but I’m having trouble and the value of the property has fallen by half. I go to the bank and say, “Look, I’ve got a problem,” and the bank says, “Okay, let’s work something out, and instead of you paying $10,000 a month, you pay us $5,000 a month and we’ll shake hands and smile.” Then, even though the property’s value has dropped, as long as we keep smiling and I’m still making payments, then the bank won’t have to reserve anything against the risk that I’ll give the building back and it will be worth a whole lot less than the mortgage.

MILLER: I think what you just described is accurate. And it’s exactly a Japanese-style solution. This is what Japan did in ‘89 and ‘90 because they didn’t want their banking system to implode, so they made it easier for their banks to sit on bad assets without owning up to the losses. 

And what’s the result? Well, it leaves the status quo in place. The real problem with this is twofold. One is that it prolongs the problem – if a bank is allowed to sit on bad assets for three to five years, it’s not going to sell them. 

Why is that bad? Well, the money tied up in the loans the bank is sitting on is idle. It is not being used for anything productive.

Wouldn’t banks know that ultimately the piper must be paid, and so they’d be trying to build cash — trying to build capital to deal with the problem when it comes home to roost?

MILLER: The more intelligent banks are doing exactly that, hoping they can weather the storm by building enough reserves, so when they do ultimately have to take the loss, it’s digestible. But in commercial real estate generally, the longer you delay realizing a loss, the more severe it’s going to be. I can tell you that because I’m out there servicing real estate all day long. Not facing the problems, and not writing down the values, and not allowing purchasers to come in and take these assets at discounted prices — all the foot-dragging allows the fundamental problem to get worse. 

In the apartment business, people are under water, particularly if they got their loan through a conduit. When maintenance is required, a borrower with a property worth less than the loan is very reluctant to reach into his pocket. If you have a $10 million loan on a property now worth $5 million, you’re clearly not making any cash flow. So what do you do when you need new roofs? Are you going to dig into your pocket and spend $600,000 on roofing? Not likely. Why would you do that?

Or a borrower who is sitting on a suburban office property — he’s got two years left on the loan. He knows he has a loan-to-value problem. Well, a new tenant wants to lease from him, but it would cost $30 a square foot to put the tenant in. Is the borrower going to put the tenant in? I don’t think so. So the problems get bigger.

Why would the owner bother going through a workout with the bank if he knows he’s so deep underwater he’s below snorkel depth?

MILLER: It’s always in your interest to delay an inevitable default. For example, the minute you give the property back to the bank, you trigger a huge taxable gain. All of a sudden the forgiveness of debt on your loan becomes taxable income to you. Another reason is that many of these loans are either full recourse or part recourse. If you’re a borrower who’s guaranteed a loan, why would you want to hasten the call on your guarantee? You want to delay as long as possible because there’s always a little hope that values will turn around. So there is no reason to hurry into a default. None.

So that’s from the borrower’s standpoint. But wouldn’t the banks want to clear these loans off their balance sheets? 

MILLER: No. The banks have a lot of incentive to delay the realization of the problem because if they liquidate the asset and the loss is realized, then they have to reserve the loss against their capital immediately. If they keep extending the loan under the rules present today, then they can delay a write-down and hope for better days. Remember, you suffer if the bank succumbs and turns around and liquidates that asset, then you really do have to take a write-down because then your capital is gone. 

So here we are, we’ve got the federal government again, through its agencies and the FDIC, ready to support the commercial real estate market. They’ve taken one step, in allowing banks to use a very loose standard for loss reserves. What else can they do?

MILLER: Well, obviously nobody knows, but I can guess at what’s coming by extrapolating from what the federal government has already done. I believe that the Treasury and the Federal Reserve now see that commercial real estate is a huge problem.

I think they’re going to contrive something to help assist commercial real estate so that it doesn’t hurt the banks that lent on commercial real estate. It’ll resemble what they did with housing.

They created a nearly perfect political formula in dealing with housing, and they are going to follow that formula. The entire U.S. residential mortgage market has in effect been nationalized, but there wasn’t any act of Congress, no screaming and shouting, no headlines in the Wall Street Journal or the New York Times about “Should we nationalize the home loan market in America.” No. It happened right under our noses and with no hue and cry. That’s a template for what they could do with the commercial loan market. 

And how can they do that? By using federal guarantees much in the way they used federal guarantees for the FHA. FHA issues Ginnie Mae securities, which are sold to the public. Those proceeds are used to make the loans.

But it won’t really be a solution. In fact, it will make the problems much more intense. 

Don’t these properties have to be allowed to go to their intrinsic value before the market can start working again?

MILLER: Yes. Of course, very few people agree with that, because if you let it all go today, there would be enormous losses and a tremendous amount of pain. We’re going to have some really terrible, terrible years ahead of us because letting it all go is the only way to be done with the problem. 

Do you think the U.S. will come out of this crisis? I mean, do you think the country, the institutions, the government, or the banking sector are going to look anything like they do today when this thing is over?

MILLER: I know this is going to make you laugh, but I’m actually an optimist about this. I’m not optimistic about the short run, and I’m not optimistic about the severity of the problem, but I’m totally optimistic as it relates to the United States of America.

This is a very resilient place. We have very resilient people. There is nothing like the American spirit. There is nothing like American ingenuity anywhere on Planet Earth, and while I certainly believe that we are headed for a catastrophe and a crisis, I also believe that ultimately we are going to come out better.

Regards,
David Galland
The Casey Report
 
Andy Miller is the co-founder of the Miller Frishman Group (MillerFrishman.com), which includes three companies serving different sectors of the real estate market – from mortgage brokerage and banking, to the building, management, and marketing of commercial real estate across the United States. His firm is currently deeply involved in the distressed real estate business, assisting lenders across the nation with their growing portfolios of non-performing loans.

February 10, 2010

An Insider’s View of the Real Estate Train Wreck was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.